Q. I am a 61-year-old retired architect. I intend to invest a large sum of money in order to get a regular income during my retirement years. I was working in the private sector and I did not receive any pension from my ex-employer. Some of my acquaintances have suggested that I invest in a dividend yield fund, however, I have limited knowledge about it and I am unsure about investing in it. Can you please elaborate the advantages and disadvantages of investing in a dividend yield fund and how are the gains from it taxed?
Sajjan Parmar, Indore, Madhya Pradesh
A dividend yield fund is a type of mutual fund that invests mostly in companies that have the potential to pay regular dividends to their shareholders. Dividends are a portion of the profits that a company distributes to its investors. A dividend yield is the ratio of the annual dividend per share to the current share price, expressed as a percentage.
For example, if a company pays ₹10 as dividend per share and its share price is Rs. 100, then its dividend yield is 10%.
A dividend yield fund aims to generate income for its investors by investing in high dividend-yielding stocks. According to the Securities and Exchange Board of India’s rules and regulations, a dividend yield fund must invest at least 65% of its assets in equity and equity-related instruments.
The fund manager selects stocks that have a track record of paying consistent dividends and have strong financials. The fund may also invest in other equity instruments or debt securities to diversify its portfolio and reduce risk.
It is important to note that in case of dividend yield funds, there is no fixed amount which is guaranteed as dividend income per month. Mutual fund investments are subject to market risks and there are no guaranteed returns.
The advantages of investing in a dividend yield fund are:
- It may provide a regular source of income for investors who seek periodic cash flows from their investments.
- It typically offers lower volatility than other equity funds, as dividend-paying stocks tend to be less affected by market fluctuations and have stable growth prospects.
- It helps investors diversify, investing a certain portion of your income in dividend yield funds diversifies your portfolio.
- Investing in a dividend yield fund reduces your risk relatively when compared to other equity mutual funds since the investee companies in the case of dividend yield funds typically are profitable and have a track record of paying dividends.
The disadvantages of investing in a dividend yield fund are:
- They may underperform other equity funds in a bullish market, as dividend paying stocks may have lower capital appreciation potential than growth-oriented stocks.
- They may expose investors to concentration risk, as dividend paying stocks may belong to a few sectors or industries that may face cyclical or structural challenges.
Dividend yield funds are classified as equity mutual funds and are taxed accordingly. Long-term capital gains (mutual fund units held for a year or more) in the case of dividend yield fund is taxed at the rate of 10% and there is an exemption for capital gains up to ₹1 Lakh in a financial year.
Short-term capital gains (mutual fund units held for less than a year) in case of dividend yield funds are taxed at the rate of 10%. Dividend income received from dividend yield mutual funds is taxable in the hands of the investors, the tax rate depends on the tax slab where they are situated.
From a taxation point of view, dividend yield fund is not a wise choice for investors who are situated in the top tax slab. This is because dividends are taxable in the hands of the investors and you may end up paying 30% tax on dividend income.
On the other hand in case of other equity mutual fund you will be paying tax only on capital gains at the rate of 10% if you hold them for a year or longer
Therefore, investors who are looking for exposure to equity without assuming too much risk and who want regular income from their investments may consider investing in a dividend yield fund.
However, they should also be aware of the limitations and risks involved in this type of fund and should diversify their portfolio across different asset classes and categories.
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Note: This is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.